Recent Finance Institution and Bank Bailout Plan Thesis

As the subprime crisis began to unfold, banks and other financial institutions around the world began to feel the weight of "toxic assets" on their balance sheets. A few such institutions found themselves at the edge of insolvency, and governments were forced to step in and bail out the ailing institutions. One of the world's largest insurance companies, AIG, received multiple bailouts, including $85 billion from the Federal Reserve Bank of New York. The fallout spread around the world. European governments were compelled to bail out their own struggling banks. Nations that had properly regulated their financial systems, such as Canada and Australia, were forced to lend financial systems because government backing had created a market distortion that gave competitive advantage to the U.S. And European institutions.

Yet, none of this is entirely new. We need only look to the savings & loan crisis to see one of the main antecedents of this decade's fiscal irresponsibility. The federal government bailed out the financial services industry then, too, creating what may well be an emerging cycle of dependency. This paper will investigate the recent bank bailout plans, and put them in historical context.

The general argument is favor of bailouts such as the one gifted to AIG is that such institutions are "too big to fail." In the case of AIG, the company's operations were intertwined with financial institutions around the world. If AIG had been allowed fail, other banks would have failed thereafter. This would have exacerbated the credit crunch of the time and further constricted the global economy. Moreover, millions of policyholders would have been left without insurance coverage to show for their investments, an undesirable outcome given that the insurance business was profitable. Thus, the failure of a large financial institution is a systemic risk as much as it is a firm-specific risk (Mishkin, 2006).

Since large bank failure is a systemic issue, the costs to the economy and therefore to government are sufficiently high that a bailout becomes a rational economic decision. Moreover, governments often view bailouts as a moral imperative. The President and Vice-President of the Minneapolis Fed argued that the too-big-to-fail problem was still persistent in the mid part of the 2000s, a view not shared by some in light of the improved governance of the FDICIA (Ibid).

The improved governance came in the early 1990s as a consequence of the savings & loan crisis, which had its roots in a real estate bubble similar to the one in the mid-2000s that precipitated the current financial crisis and bank bailouts. Deregulation was a major contributor to that crisis (Glasberg & Skidmore, 1998). The government would ultimately intervene in the financial system in order to preserve its integrity. This experience would form the core of bailout philosophy for the current situation and can be studied to provide clues as the impacts that the current bailout will have.

The S&L bailout was, in essence, the replacing of the government's implicit guarantee of deposits with the explicit funding of those deposits. The implicit guarantee has no costs, since it requires no action. Once action is taken, however, real dollars are being spent. This will have consequences in terms of taxes, interest rates and the rate at which government can borrow. Because the bailout represents a loss of wealth, it must be balanced with a decline in consumption either at present or in the future (Manchester & McKibbin, 1994).

Taking from this example, we can better analyze the current bailout. The government has made a rational economic decision with respect to these bailouts. The cost of the bailout, even into the hundreds of billions, is less than the cost to the economy if one of these banks failed. In the case of AIG, the biggest bailout recipient, the cost would have been worldwide economic devastation. Even if the supposition of some scholars was true, that FDICIA had improved regulation of the banking industry to the point where the too-big-to-fail problem no longer existed, we can see that this was not the case with the insurance industry. Indeed, the increasingly complexity of financial services has made the regulatory regime dating from the savings and loan era increasingly impotent.

The moral imperative is that the damage of not bailing out banks would be catastrophic. The bailout therefore spreads the damage among a larger group, the taxpayers, in the hopes that the damage is spread thin enough that no parties suffer devastating outcomes. However, one could also take the view that in bailing out the banks, a moral hazard is created wherein the taxpayers are being forced to suffer for the misdeeds of others. The others -- bankers -- are not made to suffer for their actions, which in turn distorts their perception of risk. If the government is going to bail them out when they get into trouble, then they will be inclined to take bigger risks (Siskey, 2008).

At the crux of the moral imperative/hazard dynamic is the mismatch of terms. The bailout is essentially using long-term funds to solve a short-term problem. With banks unable to offload toxic mortgage-backed assets, they were unable to extend credit. The credit crunch threatened to reduce economic activity substantially. Thus, the $700 billion bailout plan was enacted to shore up the credit markets. The government has structured the deal so that the Secretary of the Treasury has considerable leeway with respect to what assts to buy and what institutions to bail out (Heffes, 2008). The bailout therefore was intended to loosen the credit markets and prevent an economic collapsed. That has not been the outcome, although it is difficult at this point to determine the impact that the bailouts had on the economy. That said, the outcomes in terms of long-term cost to the taxpayers are fairly predictable. Increases in taxes and interest rates are likely outcomes, and these will in turn weigh the economy down. The damage to the economy is therefore not eliminated by the bailout, but rather spread out over a greater time frame.

Of particular interest is the case of AIG. The government took a majority ownership stake in AIG as part of that company's bailout package, whereas with the $700 billion package the government merely bought toxic assets. The moral imperative to save AIG was evident, because of the damage its failure would have caused the global economy. However, the structure of that bailout provides the taxpayers the opportunity to recover their money. This is in part because AIG has a profitable insurance business that, once decoupled from the mortgage business, can be spun off to generate return for the taxpayers. The fact that AIG has a strong ongoing business increases the likelihood that the AIG bailout will not have long-term damaging effects on the U.S. Or world economies.

The government's non-financial bailout activities should also be mentioned. These included making legal changes to allow Wells Fargo to take over Wachovia instead of Citigroup (Negotiation, 2009) and orchestrating the JP Morgan Chase takeover of Washington Mutual. These machinations allowed struggling financial institutions to be absorbed by healthier entities, thus reducing the need for government help and negative consequences to the economy. This somewhat unconventional role is, for the taxpayers, a better form of bailout since it results in the risk burden being shifted to the purchasing institution.

The $700 billion bailout, however, will have long-term damaging effects. Recent news reports indicate that the U.S. banking system is still not yet out of the proverbial woods with respect to solvency. This raises the specter of more bailouts. Given that the previous bailouts have not resulted in loose credit and economic stability, this is a worrisome prospect.

This leads us to the final point about the bailouts. The bailout is inherently a short-term measure. The stability of AIG has been assured. The other financial institutions are receiving their $700 billion in TARP funds. Yet we look back at the savings & loans debacle and that bailout. The government followed that bailout with improved regulation and governance. Even just a few years ago, scholars were debating whether or not those regulations had solved the underlying problems in the banking business that lead to the savings & loan issues in the first place. What we can see now is that those regulations were not sufficient. The banking industry has once again taken on too much risk, and is suffering the consequences.

These bailouts are, as the S&L bailout was, a means by which the government can buy time in order to make structural changes and address the underlying causes of the financial crisis. Increased regulation of the financial industry is the next step in the bailout process. Dramatic changes to the regulatory structure were being proposed before the $700 billion bailout was signed into law (Barlas, 2008). These changes will ultimately be the core of the bailout strategy, and the means by which the efficacy of the financial institution bailouts will ultimately be measured. The costs are known or can be…
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